It's not too late to ride the rally in Japanese stocks

Traders jostle to a trading counter at the Tokyo Stock Exchange February 1, 1994. REUTERS/Masaharu Hatano Japan's stock market has outperformed its global peers in a second-half rally that is a reversal from a dismal first half. The main driver? An increase in global rates and a corresponding drop in the yen. Japanese domestic sectors such as banks and brokers have also benefited from a rise in global reflationary expectations that has gathered steam since Donald Trump's surprise U.S. election win.

Is it too late to join the rally? Our take: We expect Japanese stocks to head higher in 2017, as we see plenty of interrelated reasons to like Japanese equities (on a currency-hedged basis) over the near term. These include:

A weaker yen

A weaker yen has typically boosted Japanese equities in the past, and the last few months have been no exception, as the chart below shows.

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The Japanese market as a whole remains pretty sensitive to yen movement partly because a weak yen tends to prompt index buying by overseas investors that buoys the entire market. We see further yen weakening ahead, given the Bank of Japan's (BOJ's) new policy settings.

The BOJ's new policy settings combined with global reflation

The BOJ's decision to anchor 10-year Japanese government bond (JGB) yields around zero has led to a yawning differential with 10-year Treasury yields. Reflationary expectations and Federal Reserve (Fed) rate hikes are likely to push this gap wider, further pressuring the Japanese currency. And the BOJ is arguably the least likely major central bank today to pause or reverse its accommodative policies.

Earnings

Japanese earnings revisions have started ticking higher after sliding throughout the first half. We see further upside, despite tepid domestic growth and relatively low corporate margins from an international perspective, as yen weakness should boost earnings. The bar for earnings beats has also been lowered.

Sentiment

Our big data signals of consumer sentiment (based on Internet searches) and corporate sentiment (based on text analysis of earnings transcripts and the like) are improving, suggesting sentiment is turning higher. Economic surprise indicators are on the rise, too.

Technicals

The BOJ is providing a steady bid through its purchase of exchange traded funds (roughly $50 billion a year), while large Japanese pension funds such as the Government Pension Investment Fund (GPIF) are upping their equity allocations. At the same time, companies have been ramping up their share buybacks and dividends over the past year. Nippon Telegraph & Telephone Corp., for instance, announced this month it will buyback 150 billion yen ($1.3 billion) in stock.

Momentum

Japan's equity market has recently become more momentum driven, reversing a long-standing anomaly in which Japan was the only major global market where momentum didn't work but value did. The trend is an investor's friend (but a fickle one).

There are risks to the near-term outlook for Japan, of course. They include a global risk-off shock, a drop in U.S. Treasury yields (and rebound in the yen), a China slowdown or currency devaluation—and widespread bullish broker sentiment. The consensus in favor of Japanese stocks is becoming crowded, with most major brokerages on board. This makes us nervous about how long current market trends can last. Still, investors appear to be just warming up to Japanese stocks again after a long period of shunning the market, our analysis shows.

Meanwhile, we don't see such a clear cut case for Japan over the longer term. The market has long-term positives such as political stability, a creeping but underappreciated reform momentum and the potential for a domestic shift toward embracing equities. But we worry government efforts to boost wages could crimp already low Japanese corporate margins if some Japanese firms aren't able to raise prices in response. This could potentially dash expectations for greater return of capital to shareholders.

Bottom line: Though we see lots of reasons to favor Japanese stocks for now, a fundamental improvement in corporate earnings quality and more than a weak yen are needed to sustain the rally over the longer term.